Monday, December 15, 2014

The Agrarian Revolt

I have lost count of the number of times I have heard students and faculty repeat the idea in seminars, that “all models are wrong”. This aphorism, attributed to George Box, is the battle cry of the Minnesota calibrator...

Of course all models are wrong. That is trivially true: it is the definition of a model. But the cry has been used for three decades to poke fun at attempts to use serious econometric methods to analyze time series data.

For good measure, he includes the following picture, which I am just going to steal because it's so awesome:

And here is Farmer on the Real Business Cyclists:

Time series methods were inconvenient to the nascent Real Business Cycle Program that Ed pioneered because the models that he favored were, and still are, overwhelmingly rejected by the facts. That is inconvenient.

Ed’s response was pure genius. If the model and the data are in conflict, the data must be wrong...His response was not only to reformulate the theory, but also to reformulate the way in which that theory was to be judged. In a puff of calibrator’s smoke, the history of time series econometrics was relegated to the dustbin of history...

And here is Farmer on the H-P Filter:

How did Ed achieve this remarkable feat of prestidigitation? First, he argued that we should focus on a small subset of the properties of the data...

Ed argued that the trends in time series are a nuisance if we are interested in understanding business cycles...

After removing trends, Ed was left with the wiggles. He proposed that we should evaluate our economic theories of business cycles by how well they explain co-movements among the wiggles. When his theory failed to clear the 8ft hurdle of the Olympic high jump, he lowered the bar to 5ft and persuaded us all that leaping over this high school bar was a success.

And here is Farmer on the whole dang post-RBC trend-and-cycle macro paradigm:

By accepting the neo-classical synthesis, Keynesian economists had agreed to play by real business cycle rules. They both accepted that the economy is a self-stabilizing system that, left to itself, would gravitate back to the unique natural rate of unemployment. And for this reason, the Keynesians agreed to play by Ed’s rules. They filtered the data and set the bar at the high school level.

We don't have to play by Ed's rules. We can use the methods developed by Rob Engle and Clive Granger as I have done here. Once we allow aggregate demand to influence permanently the unemployment rate, the data do not look kindly on either real business cycle models or on the new-Keynesian approach. It's time to get serious about macroeconomic science and put back the Olympic bar.

Dang, Farmer is breathing fire!! This brings me back to the good ol' days of 2011, when the Macro Wars raged in blog-land...

Anyway, Farmer seems totally right about the arbitrariness of the H-P filter and the very very very low height of the empirical hurdle represented by calibration + moment-matching.

It's also very interesting to see someone finally standing up for the idea of non-self-correcting recessions. The whole idea that "trend" and "cycle" are totally independent phenomena always seemed kind of bogus to me, especially in light of evidence like the Mankiw & Campbell "unit root in GDP" paper.

But here's the really cool thing about Farmer's attack on standard macro: it's coming from a real live macroeconomist. Most macro-bloggers I know of are either outsiders (Krugman, DeLong, etc.) or insiders who defend the dominant paradigm (Williamson, House, Wren-Lewis sort of), or nice folks who don't generally get in blogfights (Kimball). It's highly unusual to see a high-level, respected business cycle theorist come out swinging against the conventional macro wisdom.

36 comments:

There was this recent study showing, purportedly, that there's little ideological bias in economics.

First, and this is a big theme in academic economics, you're rewarded for producing the research (and with gigantic carrots and sticks), but little, if at all, for really understanding well it's implications for the real world and policy. Actually really understanding the economics that's out there and being able to apply it well to the real world and policy, to interpret it well, gets you nothing if you aren't publishing new papers. And smart explanation, interpretation to the real world and policy, is not a pub that gets rewarded. So, you often have horrible interpretation to reality and policy by super positioned and compensated economists.

Second, the bias is not in typical political English language, what that study searched for; it's in things like this; the techniques and modeling that are permitted, which so often are things that make libertarianism/plutocracy look so much better, while so much that makes libertarianism/plutocracy look so harmful are not permitted, or severely penalized in publishing and positions and rewards.

Great case in point -- When do you ever see models that include positional externalities and also just even let readers know, in a completely objective, non-normative way, what the total societal utils optimum is. Because you do this, with sensitivity analysis, and suddenly libertarian/plutocratic policy looks nightmarish. And that cannot be allowed to be seen by so many who control prestige journals and departments. All that is usually allowed is the Pareto optimum, which is complete libertarianism -- the only policy that's permitted to be considered, the only option we can know about, is the, only with unanimous consent, pure libertarianism, option. And positional externalities, the pink elephant of economics, are ignored.

It's this kind of censoring where the bias lies, and is incredibly powerful, not in overt political English language.

I doubt the webmaster is "on board" with Farmer or anyone else. But the questions he raised were good, and they deserve some kind of response, preferably a substantial one.

I have a feeling though that unless the questions come from other members of the Stanley Fischer MIT claque the response to the "Agrarian Revolt" will be "the peasants are revolting and let them eat cake."

On "They both accepted that the economy is a self-stabilizing system that, left to itself, would gravitate back to the unique natural rate of unemployment. " This is what I have been e-mailing. I'd add that the actual assumption of a unique saddle path stable long run requires more than a unique natural rate of unemployment. It also requires that technological progress is exogenous. Of course technology isn't exogenous (it is invented by people). Here from "it is too complicated to model so lets treat it as exogenous to our model" people went to "let's assume it is exogenous to our economy and therefore not affected by policy". From we know nothing to we make very strong assumptons. From we can't address the question to our attempts to answer that question haven't been refuted by the data (since they don't exist) so we should express complete confidence in our assumption that the answer is "just because":

I'm pretty sure Farmer says the new equilibrium is determined by animal spirits. Technology shocks are a positive effect. Govt. regulation is a negative one. If I'm not mistaken Farmer would have Fed run MP buy buying stocks, instead of Treasuries.

'from "it is too complicated to model so lets treat it as exogenous to our model" people went to "let's assume it is exogenous to our economy and therefore not affected by policy". From we know nothing to we make very strong assumptons.'

"All models are wrong" is only half the quote (which Box did say on numerous occasions, see: Box & Draper (1987), Empirical model-building and response surfaces, Wiley, p. 424). The other half is "but some are useful". What is implied by this (although Box politely didn't say it out loud), is that most models are not useful for much of anything. That is the real (pun intended) problem with RBC.

What I like most about Farmer is that he is a Keynesian trying to steer Keynesians away from sticky prices. Sticky wages and prices are real and contribute to recessions, but they’re an exacerbating factor not the driving force. I don’t see any evidence that he understands the driving force of recessions or anything about the credit cycle, and though that’s typical of academic Keynesians and not really a mark particularly against him, he would be in better standing to make the parrot joke if he showed some savvy about the world he’s trying to model and didn’t come off like an ivory tower model tinkerer.

As for his “search” model, I like the name. One of the main things economists need to confront is how slow a sophisticated economy is to absorb slack. Hiring is long-term team-building and tied to capital and organizational investments. Switching careers is very hard, especially after about 45. People are affluent and have family and public safety nets, most don’t have to work at McDs even if that’s all they can find. The math of the model appeared to contain no insights. But the name is good. Much better than “sticky wages.”

As for high-unemployment equilibriums, or at least high labor slack equilibriums, sure. In my experience, characteristic of weak economies with young adult bulges.

And just to clarify one point, I think a slow adjustment after a recession, which is what we've been experiencing, is not at all the same thing as absence of adjustment. Equating the two as Krugman and De Long do is wrong if not disingenuous, and though I don't see Farmer explicitly doing that, I get the feeling he might.

"I think a slow adjustment after a recession, which is what we've been experiencing, is not at all the same thing as absence of adjustment."

Adjustment to what? I think this is semantics. Economists seem to always see things in terms of "adjustment" to a new equilibrium. But in many ways this is artificial. Think of it like an historian. Or a Marxist. What I think Farmer is saying is not that we do not have adjustment, what we are having is an adjustment to new equilibrium, which is not a full employment equilibrium. An historian (and a Marxist) who does not use this artificial framework would just see this as issues relating to the dynamics of capitalism - with many factors that are causing it (this may be the irrationality of actors guided and deflation psychology - called animal spirits, it might even be welfare systems which create rigidities in the labour market and therefore price rigidity, it could be the end of a long period associated with post WWII recovery and associated productivity and multiplier effects, it could the entry of China into the system changing relative terms of trade effects and worldwide capital/labour ratios between countries etc...). It is fine to use these frameworks as a supplement to your analysis (as long as you do not believe it is fact), but the history and what is going on in the international capitalist system itself and how this affects macro-policy is what is important.

I didn’t see Farmer say whether or not he thinks the US is heading towards full unemployment. Maybe I didn’t read far enough back on his blog.

But to me, it would seem awfully silly to stake out a position right now that the US is not heading for full employment. We’re objectively moving in that direction. If we don’t get there, then I’ll be ready to talk about why not. For now we’re getting there.

It’s easy to agree that everything is always adjusting and nothing ever goes back to the past. In a sense the unemployment rate is always in a kind of equilibrium – the same kind of momentary equilibrium that stock prices are always in at any moment in time, the level where buying and selling forces equal. So if the unemployment spends a few months at 10% then starts falling, you could say it spent a few months at a high equilibrium.

But once you start using phrases like permanent or stable equilibrium, then you are talking about the sort of lasting equilibrium that, say, a gas and liquid eventually re-attain after some jolt disturbed their former one. To empirically support that kind of stable high unemployment equilibrium you’ve got to have a prolonged period of at least roughly stable high unemployment. The current US situation just does not have it.

It’s not only the old classical theorists who posited unrealistic quick returns to past trends. What I have against Krugman and De Long is they imagine that if only aggregate demand were quickly fiscal-policied back up to the old growth trend line after any slowdown or recession, the economy would continue growing along its old trend as if nothing ever happened. That to me is so utterly preposterous I suspect it’s nothing more than snake oil salesmanship – a dreamy-sounding promise that no one will ever be able to prove your medicine couldn’t have achieved, if only not for …. (fill in the blank). I’m not accusing Farmer of being that kind of Keynesian, but I get the feeling he might be.

The only question is how economies stayed stable for centuries without the benefit of the sophisticated policies and econometric methods. Or was it all chaos before with unemployment diverging wildly left and right?

The bronze age collapse in the Eastern Mediterranean, Fall of the Roman Empire, Kipper und Wipper, Tulips, South Sea bubble, famines - economies did not remain stable. It is however probably true that the complexity of the modern economy has created some new, interesting, ways for economies to go through periodic booms and busts.

The only question is how economies stayed stable for centuries without the benefit of the sophisticated policies and econometric methods. Or was it all chaos before with unemployment diverging wildly left and right?

A pathetic response. I think part of the problem is that Farmer anticipated the counter-response: "All models are wrong". OK if you think these implications of a major inconsistency in your model not important in the bigger scheme of things but just necessary for calibration purposes, just say so. By not responding you are just confirming everyone's worse fears that the economics profession is a closed shop centred around the two cliques of Chicago/Minnesota and MIT, that is not open to questions, ideas and knowledge from outside unless it is on their terms. (The first (NewClassical) goes for consistency, which while empirically dubious, is at least transparent; the latter (New Keynesian) is ad-hoc, messy and actually neither succeeds empirically or logically - and I think is the worse of the two.)

There are some questions about Farmer's attempt to merge real Keynesian economics and Walrasian economics and whether he will do a better job than the Neo-Classical Synthesis - we will get to that later, but first there is the small matter of Say's Law.